Educational Articles

The Emerging Market for Electric-Car Batteries

Tom Nikic, CFA
| January 25, 2010

In recent years, “alternative energy” has become a hot topic not only in the public eye, but in the investment community as well. Billions of dollars have been pumped into dozens of companies, both startups and existing businesses, looking to take advantage of a potentially high-growth market. However, several forms of alternative energy, including ethanol fuel and solar power, have experienced a troubling pattern of events, which starts with skyrocketing stock prices and ends with a crash down to much lower valuations. Such a pattern may have recently begun in the market for electric automobile batteries.

American dependence on the automobile has caused the country to be the world’s largest consumer of crude oil. According to the U.S. Energy Information Administration, a division of the Department of Energy, the U.S. consumed 7.14 billion barrels of oil in 2008, 23% of the world's total. Of that amount, 3.29 million barrels were used to produce motor gasoline. The public has increasingly rallied against such high levels of oil consumption, due to the resulting dependence on foreign nations and concerns about the environmental impact.

As a result, sales of hybrid cars, which use a combination of gasoline and electric power to get better fuel economy, have exploded in recent years. For instance, Toyota Motor Corporation (TM) recently announced that it sold almost 140,000 of its mid-sized hybrid vehicle, the Prius, in the U.S. in 2009. Further, several automobile manufacturers are developing plug-in electric vehicles. These cars will have a rechargeable lithium-ion battery, which holds more energy than the nickel-metal-hydride batteries found in current hybrid models. The first one to hit the road will likely be the Chevy Volt, manufactured by Detroit auto giant General Motors and expected to be available to the public by the end of 2010. Given the expected growth of the market for hybrid and electric cars, prospects for battery makers and their stocks appear to be very strong. However, the experiences of other alternative energy companies suggest a more challenging road may lie ahead.

It may be helpful to look at the ethanol industry as an example. After the turn of the millennium, elevated gasoline prices increased demand for alternative fuel sources. As a result, several companies jumped in to meet the needs of the market. According to the Renewable Fuels Association, total U.S. ethanol production rose from 1.6 million gallons in 2000 to 9.0 million gallons in 2008. Likewise, total manufacturing capacity increased from 1.75 billion gallons per year at the start of 2000 to 10.6 billion gallons nine years later, owing to a tripling in the number of production plants, from 54 to 170.

Investors were eager to pour money into ethanol companies. As an example, California-based Pacific Ethanol (PEIX) became a public entity in 2005, when the assets of ethanol company PEI California were acquired by Accessity, despite the fact that it had no experience in the biofuels industry (The acquirer’s prior operations involved medical billing recovery and automobile repair management). The following year, the company raised about $220 million in common and preferred equity. The share price shot up from less than $8 in September 2005 to almost $45 in early 2006, despite the fact that the company was still unprofitable. Though the bottom line did get into the black, the overall ethanol market was becoming saturated. Too many companies were producing too much of the biofuel, and selling prices plummeted, eroding margins. What’s more, the cost of ethanol’s primary input, corn, was rising sharply, in part due to the increased demand from ethanol producers. Pacific Ethanol’s bottom line dipped back into the red, and the company was forced to halt production at three of its four primary production plants, and the subsidiary that operates the facilities filed for Chapter 11 bankruptcy protection (the parent company did not file for bankruptcy). The share price plummeted, hitting a low of $0.20 in early 2009.

Pacific was not the only ethanol stock to experience such price movement. Shares of Archer Daniels Midland (ADM) traded as high as $47 in early 2008, before falling to $15 in October of that year. Green Plains Renewable Energy (GPRE) fell from a high of $54 shortly after going public in 2006 to about $1 in early 2009. These stocks have made partial recoveries since then, but are still trading well below their all-time highs.

This experience was not limited to ethanol companies. Solar stocks have exhibited a similar pattern. For example, First Solar (FSLR) raised about $300 million in its 2006 IPO, which, coupled with the company’s existing shares, gave the company a market capitalization of almost $1.5 billion. It also issued about $130 million in debt. The following year, First Solar raised another $365 million in equity and $50 million in debt. Meanwhile, the issue was shooting upward. The price of the IPO was $20 per share, but within 18 months, the stock hit a high of $317, giving the stock a market capitalization of about $25 billion. However, in late 2008, the share price tumbled all the way down to $85, before staging a partial recovery. Though the stock remains volatile, it has not come close to equaling the heights it reached in mid-2008.

First Solar’s remarkable climb following its IPO was probably a result excessive exuberance among investors, but the company was at least recording strong top- and bottom-line growth. The same could not be said for Evergreen Solar (ESLR), which hit the market in late 2000. After losing almost all of its post-IPO value (the share price fell below $1.00 in late 2002), the stock slowly began to climb, and the company was able to raise more and more equity capital. At the end of 2002, the company had about 11 million shares outstanding. By late 2008, there were 165 million shares, and the stock had risen to almost $19. The company had also raised about $375 million in debt. However, Evergreen had posted a deficit every year since going public in 2000, and only had one profitable quarter during that span (share earnings of a penny in the fourth quarter of 2007). The company has lost hundreds of millions of dollars since going public, topped by a roughly $85 million loss in 2008. Once again, Evergreen’s shareholders lost virtually all of their investment, as the stock plummeted to $1.00 by early 2009.

Just like in the ethanol market, increasing competition has hurt the bottom lines of solar companies. According to the Energy Information Administration, the number of companies manufacturing solar cells and modules has risen from 19 in 2004 to 66 in 2008. As a result, pricing has come under pressure. Notably, First Solar began offering rebates to customers in mid-2009, to maintain its market share. Consequently, the company reported a sharp sequential drop in earnings in the September 2009 quarter, and it also issued weak 2010 guidance. In fact, management expects its first ever annual earnings decline this year. Elsewhere, SunPower (SPWRA) reported lower sales and earnings in the first nine months of 2009, which has played a major role in the stock’s fall from a high of $165 in late $2007 to about $25 at the end of 2009. GT Solar (SOLR) has felt the competitive pressure, as a shrinking backlog suggests the company is losing market share. As a result, the stock dropped sharply following its mid-2008 IPO, from $17 to less than $2, though the issue has made a partial recovery since then.

Though it is still too early to tell, battery makers may be heading down a similar path. For instance, shares of A123 Systems (AONE) hit the market via an IPO priced at $17 a share in September 2009, raising almost $400 million in common equity and another $100 million in preferred stock. Investors pushed the stock up above $20 on the first day of trading, giving the company a market capitalization of about $2.0 billion. The share price has remained near this level, despite the fact that the company reported a September-period share loss of $1.78, a nine-month deficit of $6.06, and nine-month revenues of only $66.5 million. Another manufacturer, Ener1 (HEV), has also been posting hefty losses and lower revenues than A123, but the stock is trading at a lower valuation (the market capitalization is about $500 million).

Considering the success of A123’s IPO and the stimulus money that the Government has earmarked for electric-car batteries (about $2.4 billion), other players are sure to enter the market or attempt to aggressively expand existing operations. However, the market is already competitive, as numerous Asian firms produce batteries for hybrids and are developing lithium-ion batteries for plug-in electric vehicles. In fact, batteries for the Chevy Volt will be supplied by a division of South Korean company LG Chem. Domestic companies also face competition from Asian manufacturers like Panasonic (PC) and NEC, which have supply agreements with auto giants Toyota and Nissan, respectively. Other competitors include a joint venture between South Korean company Samsung SDI and German business Robert Bosch GmbH, as well as a venture between French company Saft S.A. and domestic manufacturer Johnson Controls (JCI). Thus, it appears the battery industry is becoming crowded quite quickly, even before considering the possibility that electric cars don’t catch on. Indeed, the potential price tag for the Chevy Volt, rumored to be as high as $40,000, may dissuade buyers, despite the fuel savings.

Though growth prospects for companies such as A123 and Ener1 appear strong, investors would be well-served to consider the experiences of the ethanol and solar power markets as cautionary tales. It is easy to get caught up in the hype surrounding a hot new technology, but the hoopla often leads to an influx of competitors, overcapacity in production, and unreasonably expensive stock valuations. This might not happen in the battery market, but investors should consider these factors before committing funds to companies in this emerging industry.